“Rolling It Forward” for Profitable Trading (Part 2)

03/25/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

I haven't yet mentioned leverage. Though many brokers will let you trade three or four e-mini S&P contracts per $10,000, by doing so, you are exposing your account to extremely large percentage swings on each and every trade. Overtrading (trading too frequently) and using too much leverage will drain an account faster than anything else, and people who lose all the money in their accounts are generally guilty of both of these.

I understand not everyone has $100,000 for their trading accounts, or $50,000, or even $25,000. Many of you scraped about $10,000 together, or a touch less, to begin trading. Think of this money as your "trading university" funding. You need to practice, practice, practice, without losing all your capital. Using simulated trading is fine, up to a point, but eventually, you will have to trade using real money, because only then will you experience all the positive and negative emotions that you have to master before you can become a consistently successful trader.

If you are trading a $10,000 account (or something close to that), if you choose to trade e-mini S&P futures, learn while trading only one contract. That one contract will give you all the spills, chills, and thrills you can handle, and then some. The goal is to survive the learning period with as much of your capital intact as possible. No matter what instrument you decide to trade, use leverage carefully, use consistently sized, smaller stops, and don't take a trade just to take a trade: Have a trading plan and use it!

The trader in our recent example continued to use a large initial stop (seven S&P points) for his fourth trade, because he saw what he thought was a great setup right after lunch. Price was trading in a range, and when it broke out, he'd catch the move. This was going to be a sure 16-point winner and it would get him all the money he had lost on the last trade and a little more! He had two winners in a row, and that last large loser was because of the opening gap, but it was the afternoon now, and he was sure he'd get his money back by the close.

Price broke out to the upside and he went long, just as he had in the morning. He was sure now that they'd fill the gap left on the open. Price broke above the top of the range and he put his initial stop loss well below the bottom of the range.

Price went a little higher after he went long, but then it broke back into the trading range, and a few bars later, it headed towards the low of the trading range. Soon, he was looking at where his stop was placed and where price was trading and he realized he had only put his stop loss order one S&P point below the low of the range! He decided that was too close to the prior lows and they might "wash and rinse" him and then take price back higher, but he wasn't going to let that happen! He moved his stop loss order to a worse level to give the trade more room. Now he was risking ten S&P points to make 16 S&P points. The size of his stop was huge and his risk/reward ratio was only 1.6:1.

They did wash and rinse those traders who had tried to go long at the bottom of the range. He breathed a sigh of relief when he wasn't stopped out and price climbed back into the range. But the relief didn't last long. Two bars later, price headed lower again, and this time, ran into quite a few stop loss orders. The selling continued and he was quickly stopped out for his second losing trade.

Please take the time to notice that the size of his two losing trades were much larger than the size of his two winning trades. When you look at your trading statistics (and I hope you all keep trading statistics and review them regularly), this is a sign you are on the road to ruin.

NEXT: What to Learn from Another Badly Failed Trade

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When he eyed up what would be his fifth trade, he decided he had been risking too much on each trade. He decided to go back to the five S&P point stop he had used for his first trade. Three S&P points seemed too small, and he didn't want to lose seven more S&P points, so he settled on five S&P points. He had used five points on his largest winning trade, and that one worked pretty good.

Price started to sell off on the opening, and after watching it head lower for a while, he decided the selloff was probably going to continue. He found a place on his chart where price had run into resistance yesterday afternoon, and when price got to that area, he got short three S&P contracts.

Price congested underneath this area for five or six bars. To him, it felt like there was a giant order to sell just above the market! Other traders also had this feeling that there was a giant seller just above the market, and more and more short S&P positions were created right below this resistance area. 

Price suddenly began to spike higher. He looked at his charts again and realized he had placed his stop loss order right at the bottom of that trading range from yesterday, so he moved it higher, now risking eight S&P points on the trade, but he was confident the bottom of the range from yesterday would stop the rise. And it did stop the rise.for a few bars.

Then price began to creep higher, slowly edging into the trading range. As soon as he began to feel his stop loss order was in danger of being executed, his first thought was "I can't take another large losing trade!" The last two losses had really cut into his trading account. He was certain price was just about to turn around and head lower, so he couldn't allow them to stop him out of his short position now! He moved his stop loss order higher (for the second time) by four more S&P points.

The end of this trade came swift this time. Roughly two minutes after he cancelled his stop loss order and moved it higher by four points, price spiked much higher, taking him out of his position with a 12 S&P point loss.

In three trading days, he managed to have two winners and three losers. That's not a fatal win/loss ratio. In fact, if he had an actual risk/reward ratio above 3:1, he would have net made money. But in his five trades, he had made seven S&P points and lost 35 S&P points! You don't even have to do the math to know that that risk/reward ratio was fatal.

In three trading days, he managed to take a $10,000 trading account and lose $4,200 of it. And the sad truth was he wasn't really trading a $10,000 account! I proportionally downsized everything-his account, and the position sizes, profits, and losses-to a $10,000 account so most of you would better relate to the sizes of the wins and losses. He was actually trading with a multi-million dollar account, so imagine how much money he actually lost!

"Where did I go wrong," he asked me when we met at the end of the week. I started to list the mistakes, and he had made most of the mistakes I have on my "Don't Ever Do This" list:

  1. Don't use too much leverage. Once you become a consistently profitable trader, there are simple ways to slowly increase your position size without emptying your account.
  2. Keep your stops relatively small. Stops are often your best friends. By using consistently sized maximum stops, you'll be around much longer to learn your trading skills.
  3. Never trade without stops, and never move your stops to a worse level. Once the trade begins, you have emotions tugging at you and you often make poor judgments. In my opinion, your first thoughts about a trade are usually the best because they came before this emotional tug of war.
  4. A solid actual risk/reward ratio pays for many sins. If your actual risk/reward ratio is 3:1 or better, you can have three or four losses in a row, and if you are using consistently sized, smaller stops, you can still have a good month.
  5. When you take a trade, don't think about getting the money back. Take trades because they make sense. The market has no memory, so trying to take revenge on the market is a waste of emotional energy, and these "revenge trades" seldom work.
  6. If you find you have had several bad losses in a row, try taking a few days off to let your head clear and then evaluate what you were doing that led to the large losses. Make certain you learn something from your mistakes!
  7. Set "circuit breaker" levels in your trading account, perhaps at every 10%. If you lose 10% of your account, take some time off, then re-evaluate your trading plan. If you are trading multiple contracts, you must lower your number of contracts at one of these "circuit breaker" levels. If you manage to make back the 10%, you can always slowly increase your number of contracts.
  8. Set rules for yourself and never violate them. If you violate a rule, impose a stiff penalty on yourself, a week off trading perhaps. When you violate rules, it is a clear sign that you are out of control.

So what should a solid five trades look like? We'll study that tomorrow in Part 3.

More tomorrow in Part 3. Read Part 1

By Tim Morge of MarketGeometry.com

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